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date: 12 July 2020

Abstract and Keywords

To reduce moral hazard and systemic risk, regulators require banks to hold capital in order to absorb unforeseen risks. Standards developed by the Basel Committee on Banking Supervision (via Basel I and Basel II) have gone some way to aligning such capital requirements with banks' risk profiles. This article examines the rationale for capital regulation and describes the key features of Basel II. It focuses on the theoretical and empirical underpinnings of Basel II, and the challenges in rating the riskiness of assets contained in bank portfolios. A key issue identified is the extent to which the bank risk rating systems are responsive to changes in borrower default risk over the business cycle. If this is indeed the case, capital requirements under the Internal-Ratings-Based approach will increase as an economy moves into recession and decline as an economy moves an expansion. Basel II is likely to make it more difficult for policymakers to maintain macroeconomic stability if banks' lending is procyclical.

Keywords: capital requirements, banking regulation, capital regulation, bank risk rating, borrower default risk, bank lending

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